Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 5 Bank Credit

Credit to SSI & Other Sectors

Credit to SSI

Small scale industries (SSIs) play a significant role in terms of balanced and sustainable growth, employment generation, development of entrepreneurial skills and contribution to export earnings. In particular, there is need to develop entrepreneurship in developing countries and, in this context, small-scale units play an important role. It is relevant to note that a unit which is small today could be a big unit tomorrow. At the same time, SSI units are hampered in their growth by imperfections in all the key factor markets - capital, land and labour - but, in particular, capital markets. Capital costs faced by SSI units are typically higher because of market imperfections in the availability of information for investors and lenders. Given the relatively small size of loans, transaction costs are also higher for SSI units. Provision of collateral or other risk-reducing securities is also often difficult for SSIs. On all these grounds, credit flow to small scale units may be less than desirable. This provides a strong rationale for policy intervention to direct credit flow to the SSI units.

Like many countries, in India too, efforts have, therefore, been made to increase provision of credit to this sector. This has taken the form of requiring banks to allocate a stipulated proportion of their total credit to the SSI sector. Advances to SSI are accordingly a part of the priority sector lending since the 1970s. Before the initiation of financial sector reforms in the early 1990s, these loans were subsidised. In the post-reform period, higher transaction costs and the absence of good credit assessment capabilities with banks engendered by the earlier regime led to a significant jump in interest rates applicable to SSI units. The high interest rates paid by the SSIs may not always be in accordance with their risk profile.

Efforts have, therefore, been made in the recent years to increase flow of credit to this sector while reducing transactions costs for lending. Initiatives to increase flow of credit to the SSI sector include: opening of specialised SSI branches; fixing of self-target for SSI sector by banks; enhancement in the limit for composite loans; delegation of more powers to branch managers; simplification of loan application forms; launching of a new Credit Guarantee Scheme; and collateral free-loans. In order to further enhance the flow of credit to this sector, a Working Group on Flow of Credit to SSI Sector (Chairman: Dr. A.S. Ganguly) was recently constituted by the Reserve Bank. The Group submitted its Report in April 2004 (Box VI.3). Following the Group's Report, the Reserve Bank's Annual Policy Statement for 2004-05 stated that Credit Information Bureau of India Ltd. (CIBIL) would work out a mechanism, in consultation with the Reserve Bank, SIDBI and IBA for developing a system of proper credit records. As noted above, a key factor that inhibits lending to the SSI sector is limited information that banks have about borrowers. The proposal to develop a set of credit records will enable an easier verification of credit histories and thereby increase flow of credit. Empirical evidence for the US shows that wider availability of credit histories have greatly expanded the availability of credit as potential borrowers are no longer tied to their local lenders. Small firms in the US have been able to borrow from increasingly distant lenders over time. Given this evidence, the proposed measures of developing credit record through CIBIL should widen the available resources to SSI units as also reduce their cost. With mechanisms such as credit histories in place, financiers can also move away from lending only against collateral or on the basis of prior contacts.

The access to credit for the poor from conventional banking is often constrained by lack of collateral and high transaction costs associated with small borrowal accounts. It has been demonstrated that timely and adequate access to credit can help alleviate poverty, the prime example being the success of the Grameen Bank model of Bangladesh. It is possible for even the organised financial intermediaries to lend to the poor at market determined interest rate with high rates of recovery and low transaction costs. In this context, micro finance has emerged as a viable alternative to reach the underprivileged sections of society for their social and economic empowerment through financial intermediation. Micro finance involves provision of thrift, credit and other financial services and products of very small amounts to the poor for enabling them to raise their income levels and thereby improve living standards.

In this regard, a number of initiatives have been taken to augment the flow of bank credit to the micro enterprises in rural and semi-urban areas set up by vulnerable sections of society including women. Banks have been advised to provide maximum support to Self Help Groups (SHGs). A SHG is a registered or unregistered group of micro entrepreneurs with a homogenous social and economic background, voluntarily coming together to save small amounts regularly and mutually agreeing to contribute to a common fund to meet their emergency needs on mutual help basis. The group members use collective wisdom and peer pressure to ensure proper end-use and timely repayment of credit. In fact, peer pressure has been recognised as an effective substitute for collaterals. Besides, financing through SHGs reduces transaction costs for both lenders and borrowers. Accordingly, the Reserve Bank has put in place a facilitating environment for banks to promote SHGs. Since 1996, financing of SHGs is a part of priority sector lending. More recently, banks have been advised to provide adequate incentives to their branches for financing SHGs, establishing linkages and adopting simple and easy procedures to suit local conditions. The ambit of microfinance has been extended to include consumption expenditure. Banks have been advised that the group dynamics of SHGs need not be regulated and there is no need to impose or insist upon formal structures.

The importance of the housing sector in any economy is derived from its high employment potential and extensive backward and forward linkages. In addition to being an engine of growth for the economy, the housing sector provides a relatively safe destination for bank credit on account of relatively high recovery rates. Consequently, the Reserve Bank has initiated a host of supply side measures to boost flow of bank credit to the housing sector and to ensure the benefit of soft interest rates to borrowers. These include: (a) contribution of Rs.100 crore to the equity capital of NHB; (b) reduction in risk weight on loans from 100 per cent to 50 per cent; (c) investments in Mortgage Backed Securities (MBS) reckoned in the prescribed housing finance allocation of 3.0 per cent; (d) increase in limit on housing loans for repairing damaged houses in rural, semi-urban and urban areas; and (e) direct finance to the housing sector up to Rs.10 lakh in rural and semi-urban areas as part of priority sector lending.

Financing of infrastructure projects is characterised by large capital outlays, long gestation period and high leverage ratios. Once an infrastructure project is built, and tariffs are set in a transparent and predictable manner, the cash flows are fairly regular and predictable. They can then be securitised easily. However, the pre-operation risk is extremely high: hence risk mitigation, and credit enhancement is necessary to attract resources at reasonable cost. Taking into account such special considerations involved in the funding of the infrastructural sector as also the need to facilitate private sector investment in infrastructure, several policy measures have been implemented by the Reserve Bank. In April 1999, the Reserve Bank introduced new guidelines relating to the financing of infrastructure projects, such as, the criteria for financing, the types of financing, the appraisal, the regulatory compliance/concerns, the administrative arrangements and the inter-institutional guarantees. Certain relaxations relating to regulatory and prudential aspects have been allowed to banks since 1999-2000 to boost flow of credit to this sector. These measures, inter alia, included:

1. enhancing the scope of definition of infrastructure lending;

2. relaxing the prudential single borrower exposure limit from 15 per cent to 20 per cent of capital funds in respect of infrastructure companies providing infrastructure facilities;

3. assigning a concessional risk weight of 50 per cent on investment in securitised paper satisfying certain conditions pertaining to an infrastructure facility;

4. permitting lending to special purpose vehicles (SPVs) in the private sector registered under Companies Act for directly undertaking viable infrastructure projects subject to certain conditions;

5. lending to promoters, with certain safeguards and where appropriate, for acquiring a controlling stake in existing infrastructure companies; and

6. expanding the scope of definition of infrastructure lending to include the construction of projects involving agro-processing and supply of inputs to agriculture, preservation and storage of processed agro-products and perishable goods, educational institutions and hospitals.